Depending on each spouse’s perspective, business valuation in a divorce can lead to sticker shock, disappointment, or both. The business operating spouse (who wants to keep the business after the divorce) usually wants the business to have a lower value, so they can be awarded both the business as well as other marital assets. The other spouse generally wants the business valued higher, so they can receive a larger portion of the other assets or, better yet, all of the other assets plus a buyout for the value of the business exceeding the value of all the other assets received.
A business is valued based on its fair market value. Fair market value means the amount that would be paid in cash by a willing buyer who desires to buy, but is not required to buy, to a willing seller who desires to sell, but is under no necessity of selling.
In a divorce, experts (normally CPAs accredited in business valuation) are hired by one or both sides to conduct a business valuation. A business valuation is essentially an appraisal (i.e. professional estimate) of the company’s fair market value. Experts can arrive at roughly similar values or radically different values, despite analyzing the same financial information. These differences occur for a variety of reasons and much of it has to do with the mechanics of a business valuation.
There are three broad approaches (with various potential methodologies within each) to valuing a business: (1) the asset approach; (2) the market approach; and (3) the income approach.
The asset approach generally calculates the value of a company based on the value of the company’s underlying assets net of liabilities. The market approach determines the value of a company by comparing it to similarly situated companies that have sold in similar markets. The income approach values a company by using current and prior economic data to project future economic benefits of the company and then converting those projected future economic benefits to a present value.
The valuation approach (or approaches) used by one expert may differ from another. There are guidelines for when to use each approach, but these are not rigid, mandatory rules. It is not uncommon for an expert to use, or at least consider, one or more of the three approaches. Moreover, each expert may have a justifiable reason for choosing the approach they used.
The Goodwill Difference
Goodwill is a factor in the value of a business. Texas recognizes two types of goodwill: (1) personal goodwill; and (2) commercial goodwill. Personal goodwill is the goodwill of a business attributable to an individual’s skills, abilities, and reputation. Commercial goodwill is the goodwill attributable to the business itself as well as its brands and reputation.
Importantly, a divorce court cannot include the value of personal goodwill in the fair market value of a business, but commercial goodwill is included. The role of an expert is to determine the extent to which the individual owner’s skills and reputation (i.e. personal goodwill) account for the company’s success or prosperity, if any. Then, an expert will usually first calculate the total value of the business and then deduct from that total value the portion attributable to personal goodwill to arrive at their fair market value determination.
Adjustments to Financial Statements
Experts often adjust a company’s financial statements for purposes of valuation. There are a wide variety of adjustments that can be made. One category of adjustments is “normalizing” adjustments. Normalizing adjustments are often made to weed out anomalous expenses or income that are not expected to be incurred or received in the future.
Additionally, experts can adjust financial statements for items such as owner compensation (whether it is too high or too low) and ongoing capital expenditures if the business requires regular capital expenditures to operate.
Discounts – Lack of Marketability and Control
Experts can also discount the value of a business based on a lack of marketability and/or a lack of control. These discounts often go hand-in-hand.
Marketability deals with how difficult the ownership interest might be to sell, market availability for the ownership interest, and whether there are any restrictions on the ability to sell or transfer the ownership interest.
Control deals with what rights, powers, or restrictions may be attached to the ownership interest such as managerial rights, control over operations, the ability to order cash distributions, or the ability to liquidate company assets.
The less control and marketability of the ownership interest, the greater the discount that will be applied to the enterprise value of the company.
Priorities of Information
Experts have to review and prioritize a substantial amount of information when valuing a business. They determine what facts or information are most germane and indicative of a company’s true fair market value. But, businesses are constantly in flux. There are good years and bad years. New avenues of profitability are regularly evaluated, pursued, or dismissed. A previously profitable endeavor may be declining. A new endeavor may be promising but have limited data. Some financial data or reporting may be misleading or inconsistent. As such, different experts may place different emphasis, weight, or credibility on different pieces of information.
Ultimately, experts have a substantial amount of professional discretion, within proper valuation guidelines, that can affect their final fair market value determination.